macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich macro © 2004 Worth Publishers, all rights reserved CHAPTER FIVE The Open Economy

CHAPTER 5 The Open Economy slide 1 Investment: The Demand for Loanable Funds Investment is still a downward-sloping function of the interest rate, r *r * but the exogenous world interest rate… …determines the country’s level of investment. I (r* ) r S, I I (r )I (r )

CHAPTER 5 The Open Economy slide 2 If the economy were closed… r S, I I (r )I (r ) rcrc …the interest rate would adjust to equate investment and saving:

CHAPTER 5 The Open Economy slide 3 But in a small open economy… r S, I I (r )I (r ) rcrc r* I 1I 1 the exogenous world interest rate determines investment… …and the difference between saving and investment determines net capital outflows and net exports NX

CHAPTER 5 The Open Economy slide 4 Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand

CHAPTER 5 The Open Economy slide 5 1. Fiscal policy at home r S, I I (r )I (r ) I 1I 1 An increase in G or decrease in T reduces saving. NX 1 NX 2 Results:

CHAPTER 5 The Open Economy slide 6 2. Fiscal policy abroad r S, I I (r )I (r ) Expansionary fiscal policy abroad raises the world interest rate. NX 1 NX 2 Results:

CHAPTER 5 The Open Economy slide 7 3. An increase in investment demand r S, I I (r )1I (r )1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX 1 I 1I 1 S

CHAPTER 5 The Open Economy slide 8 3. An increase in investment demand r S, I I (r )1I (r )1 ANSWERS:  I > 0,  S = 0, net capital outflows and net exports fall by the amount  I NX 2 NX 1 I 1I 1 I 2I 2 S I (r )2I (r )2

CHAPTER 5 The Open Economy slide 9 The nominal exchange rate e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar or Euro per dinar, per...)

CHAPTER 5 The Open Economy slide 10 The real exchange rate = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac) the lowercase Greek letter epsilon ε

CHAPTER 5 The Open Economy slide 11 Understanding the units of ε ε

CHAPTER 5 The Open Economy slide 12  one good: Big Mac  price in Japan: P* = 200 Yen  price in USA: P = $2.50  nominal exchange rate e = 120 Yen/$ To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. ε ~ McZample ~

CHAPTER 5 The Open Economy slide 13 ε in the real world & our model  In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods  In our macro model: There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output

CHAPTER 5 The Open Economy slide 14 How NX depends on ε  ε  U.S. goods become more expensive relative to foreign goods   EX,  IM   NX

CHAPTER 5 The Open Economy slide 15 U.S. Net Exports and the Real Exchange Rate,

CHAPTER 5 The Open Economy slide 16 The net exports function  The net exports function reflects this inverse relationship between NX and ε: NX = NX (ε )

CHAPTER 5 The Open Economy slide 17 The NX curve for the U.S. 0 NX ε NX( ε ) ε1ε1 When ε is relatively low, U.S. goods are relatively inexpensive NX( ε 1 ) so U.S. net exports will be high

CHAPTER 5 The Open Economy slide 18 The NX curve for the U.S. 0 NX ε NX( ε ) ε2ε2 At high enough values of ε, U.S. goods become so expensive that NX( ε 2 ) we export less than we import

CHAPTER 5 The Open Economy slide 19 How is determined How ε is determined  The accounting identity says NX = S  I  We saw earlier how S  I is determined: S depends on domestic factors (output, fiscal policy variables, etc) I is determined by the world interest rate r *  So, ε must adjust to ensure

CHAPTER 5 The Open Economy slide 20 How is determined How ε is determined Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε NX NX(ε ) ε adjusts to equate NX with net capital outflow, S  I. ε 1ε 1 NX 1

CHAPTER 5 The Open Economy slide 21 Interpretation: supply and demand in the foreign exchange market demand: Foreigners need dollars to buy U.S. net exports. ε NX NX(ε ) supply: The net capital outflow (S  I ) is the supply of dollars to be invested abroad. ε 1ε 1 NX 1

CHAPTER 5 The Open Economy slide 22 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports

CHAPTER 5 The Open Economy slide Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. ε NX NX(ε ) ε 1ε 1 NX 1 NX 2 ε 2ε 2

CHAPTER 5 The Open Economy slide Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market… …causing the real exchange rate to fall and NX to rise. ε NX NX(ε ) NX 1 ε 1ε 1 ε 2ε 2 NX 2

CHAPTER 5 The Open Economy slide An increase in investment demand An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange market… ε NX NX(ε ) …causing the real exchange rate to rise and NX to fall. ε 1ε 1 NX 1 NX 2 ε 2ε 2

CHAPTER 5 The Open Economy slide Trade policy to restrict imports ε NX NX (ε ) 1 NX 1 ε 1ε 1 NX (ε ) 2 At any given value of ε, an import quota  IM  NX  demand for dollars shifts right Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remains fixed. ε 2ε 2

CHAPTER 5 The Open Economy slide Trade policy to restrict imports ε NX NX (ε ) 1 NX 1 ε 1ε 1 NX (ε ) 2 Results:  ε  > 0 (demand increase)  NX = 0 (supply fixed)  IM < 0 (policy)  EX < 0 (rise in ε ) ε 2ε 2

CHAPTER 5 The Open Economy slide 28 The Determinants of the Nominal Exchange Rate  Start with the expression for the real exchange rate:  Solve it for the nominal exchange rate:

CHAPTER 5 The Open Economy slide 29 The Determinants of the Nominal Exchange Rate  So e depends on the real exchange rate and the price levels at home and abroad…  …and we know how each of them is determined:

CHAPTER 5 The Open Economy slide 30 The Determinants of the Nominal Exchange Rate  We can rewrite this equation in terms of growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ) :  For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.

CHAPTER 5 The Open Economy slide 31 Inflation and nominal exchange rates Percentage change in nominal exchange rate Inflation differential Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar France Canada Sweden Australia UK Ireland Spain South Africa Italy New Zealand Netherlands Germany Japan Belgium Switzerland

CHAPTER 5 The Open Economy slide 32 Purchasing Power Parity (PPP) Two definitions: –a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. –the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: –arbitrage, the law of one price

CHAPTER 5 The Open Economy slide 33 Purchasing Power Parity (PPP)  PPP: e  P = P* Cost of a basket of domestic goods, in foreign currency. Cost of a basket of domestic goods, in domestic currency. Cost of a basket of foreign goods, in foreign currency.  Solve for e : e = P*/ P  PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels.

CHAPTER 5 The Open Economy slide 34 Purchasing Power Parity (PPP)  If e = P*/P, then and the NX curve is horizontal: ε NX ε = 1 S  I Under PPP, changes in (S  I ) have no impact on ε or e.

CHAPTER 5 The Open Economy slide 35 Does PPP hold in the real world? No, for two reasons: 1.International arbitrage not possible.  nontraded goods  transportation costs 2.Goods of different countries not perfect substitutes. Nonetheless, PPP is a useful theory: It’s simple & intuitive In the real world, nominal exchange rates have a tendency toward their PPP values over the long run.

CHAPTER 5 The Open Economy slide 36 no change               closed economy small open economy actual change ε NX I r S G – T 1980s1970s Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. CASE STUDY The Reagan Deficits revisited

CHAPTER 5 The Open Economy slide 37 The U.S. as a large open economy  So far, we’ve learned long-run models for two extreme cases:  closed economy (chapter 3)  small open economy (chapter 5)  A large open economy --- like the U.S. --- is in between these two extremes.  The analysis of policies or other exogenous changes in a large open economy is a mixture of the results for the closed & small open economy cases.  For example…

CHAPTER 5 The Open Economy slide 38 NX I r large open economy small open economy closed economy A fiscal expansion in three models falls, but not as much as in small open economy falls no change falls, but not as much as in closed economy no change falls rises, but not as much as in closed economy no change rises A fiscal expansion causes national saving to fall. The effects of this depend on the degree of openness:

CHAPTER 5 The Open Economy slide 39 Chapter summary 1. Net exports--the difference between  exports and imports  a country’s output (Y ) and its spending (C + I + G) 2. Net capital outflow equals  purchases of foreign assets minus foreign purchases of the country’s assets  the difference between saving and investment 3. National income accounts identities:  Y = C + I + G + NX  trade balance NX = S  I net capital outflow

CHAPTER 5 The Open Economy slide 40 Chapter summary 4. Impact of policies on NX :  NX increases if policy causes S to rise or I to fall  NX does not change if policy affects neither S nor I. Example: trade policy 5. Exchange rates  nominal: the price of a country’s currency in terms of another country’s currency  real: the price of a country’s goods in terms of another country’s goods.  The real exchange rate equals the nominal rate times the ratio of prices of the two countries.

CHAPTER 5 The Open Economy slide 41 Chapter summary 6. How the real exchange rate is determined  NX depends negatively on the real exchange rate, other things equal  The real exchange rate adjusts to equate NX with net capital outflow 7. How the nominal exchange rate is determined  e equals the real exchange rate times the country’s price level relative to the foreign price level.  For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates.

CHAPTER 5 The Open Economy slide Balassa Samuelson 7. Dutch disease - oil - donations - keynes: reparations payments by Germany

CHAPTER 5 The Open Economy Political economy of the exchange rate policy  Winners of appreciation –Pensioners –Wage recipients –Importers –The central bank (lower inflation) –Losers have less political power than winners –Case of Hungary: road to indebtdness slide 43

CHAPTER 5 The Open Economy Two goals, one instrument  Stability of prices –i.e. nominal exr must be constant  Preventing export destimulation –i.e. Real exr must be at least constant –Better policy in transition slide 44

CHAPTER 5 The Open Economy The currency can appreciate...  But in comparison to what?  NOMINAL EXR - NER  REAL EXR – RER –REER – REAL EFECTIVE EXR  EQUILIBRIUM EXR –THE ONE THATE MAKES NX TO BE ZERO IN THE MEDIUM run!!!!! slide 45

CHAPTER 5 The Open Economy  slide 46 Slika 7.8 Primary current accout in Period 2) Real exchange rate (P N /P T ) 0 Ravnotežni realni devizni kurs A´ A  )) PTR (

CHAPTER 5 The Open Economy Can real equilibrium exchange rate change?  Yes  Debt rescheduling  Debt relief –Poland –Albania was not given money for exr slide 47

CHAPTER 5 The Open Economy  How can we tell whether a currency is appreciated –Easily –If a country runs ft deficit for a long time –Its  currency must be appreciated  But the argument goes that depreciation will not boost exports –Governors love this argument slide 48

CHAPTER 5 The Open Economy  Speculative attacks can be prevented only by introducing flexible exchange rate slide 49

CHAPTER 5 The Open Economy What’s on the menu?  Free floating  Managed floating  Target zones  Crawling pegs  Fixed and adjustable  Currency boards  Dollarization/euroization  Monetary union

CHAPTER 5 The Open Economy The choice of an exchange rate regime  The monetary policy instrument –Can be useful to deal with cyclical disturbances –Can be misused (inflation)  The fiscal policy instrument –Can also deal with cycles but is often politicized –Can be misused (public debts, political cycles)  Exchange rate stability –Freely floating exchange rates move “too much” –Fixed exchange rates eventually become misaligned

CHAPTER 5 The Open Economy The old debate: fixed vs. float  The case for flexible rates –With sticky prices, need exchange rate flexibility to deal with shocks –Remove the exchange rate from politicization –Monetary policy is too useful to be jettisoned  The case for fixed rates –Flexible rates move too much (financial markets are often hectic) –Exchange rate volatility: a source of uncertainty –A way of disciplining monetary policy –In presence of shocks, always possible to realign

CHAPTER 5 The Open Economy The new debate: the two-corners solution  Only pure floats or hard pegs are robust –Intermediate arrangements (soft pegs) invite government manipulations, over or under valuations and speculative attacks –Pure floats remove the exchange rate from the policy domain –Hard pegs are unassailable (well, until Argentina’s currency board collapsed…)  In line with theory –Soft pegs are half-hearted monetary policy commitments, so they ultimately fail